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CHAPTER 1
Financial Instruments
LEARNING OBJECTIVES
After studying this chapter, you should have a grasp of the following concepts:
- Accounting standards for financial instruments.
- Definition of financial instruments.
- Financial assets and financial liabilities.
- Categories of financial instruments.
- Fair value measurement concepts.
- Recognition and derecognition of financial instruments.
- Types of investments.
- Difference between investment and speculation.
- Two major accounting standards: U.S. GAAP and IFRS.
- Hierarchy of U.S. GAAP and IFRS.
ACCOUNTING STANDARDS FOR FINANCIAL INSTRUMENTS
The topic of accounting standards for financial instruments covers the following aspects:
- Definition of financial instrument, financial asset, financial liability, and equity instrument.
- Definition of a derivative instrument.
- Different types of contracts that are covered within the scope of the accounting standards for financial instruments.
- Four categories of financial instruments.
- Fair value and fair value determination.
- Accounting treatment of different categories of financial instruments.
- Recognition and derecognition of financial instruments.
- Initial measurement and subsequent measurement of financial instruments.
- Effect of changes in fair value.
- Reclassification and its impact.
- Impairment and its treatment for different categories.
- Hedge accounting concepts.
The synopsis of the accounting standards under the International Financial Reporting Standards (IFRS), IAS 39, is given in Appendix B.
Relevant Accounting Standards
| U.S. GAAP | IFRS |
FAS 52—Foreign Currency Translation
FAS 94—Consolidation of All Majority-owned Subsidiaries
FAS 109—Accounting for Income Taxes
FAS 115—Accounting for Certain Investments in Debt and Equity Securities
FAS 130—Reporting Comprehensive Income
FAS 157—Fair Value Measurements
FAS 159—The Fair Value Option for Financial Assets and Financial Liabilities | IFRS 7—Financial Instruments: Disclosure
IAS 21—The Effects of Changes in Foreign Exchange Rates
IAS 32—Financial Instruments: Presentation
IAS 36—Impairment of Assets
IAS 39—Financial Instruments: Recognition and Measurement |
DEFINITION OF FINANCIAL INSTRUMENTS
A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Investments in equity shares are a form of financial instrument.
Financial Assets and Financial Liabilities
A financial asset is defined as one of the following types of assets, according to the accounting standards:
- Cash.
- An equity instrument of another entity.
- A contractual right:
- To receive cash or another financial asset from another entity.
- To exchange financial assets or financial liabilities with another entity under conditions, potentially favorable to the entity.
- A contract that will or may be settled in the entity’s own equity instruments and is:
- A non-derivative resulting in receiving a variable number of the entity’s own equity instruments.
- A derivative that will or may be settled other than by the exchange of a fixed amount of cash or other financial asset for a fixed number of the entity’s own equity instruments.
A financial liability is defined as one of the following types of liabilities, according to the accounting standards:
- A contractual obligation:
- To deliver cash or another financial asset to another entity.
- To exchange financial assets or financial liabilities with another entity under conditions, potentially unfavorable to the entity.
- A contract that will or may be settled in the entity’s own equity instruments and is:
- A non-derivative resulting in delivering a variable number of the entity’s own equity instruments.
- A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
Equity Instrument
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
Derivative
A derivative is a financial instrument or other contract with all three of the following characteristics:
1. Its value changes in response to the change in an underlying.
2. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts.
3. It is settled at a future date.
CATEGORIES OF FINANCIAL INSTRUMENTS
The four basic categories of financial instruments are:
1. Fair value through profit and loss (FVPL).
2. Held-to-maturity (HTM).
3. Available-for-sale (AFS).
4. Loans and receivables (LAR).
Investments in equity shares, futures, and equity options are classified as either fair value through profit and loss or as available-for-sale securities only. Investments in equity shares cannot be classified as held-to-maturity as there is no maturity period for equity shares. Redeemable preference shares can be classified as loans and receivables. Loans and receivables are not defined under the U.S. GAAP as a separate category, even though IAS 39 under IFRS has this category.
Fair Value through Profit and Loss (FVPL)
A financial asset or financial liability at fair value through profit or loss is one that meets either of the following two conditions:
1. It is classified as held for trading—in other words, one of the following statements is true:
- It is acquired or incurred principally for the purpose of selling or repurchasing it in the near term.
- It is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking.
- It is a derivative other than a financial guarantee contract or for hedging purposes.
2. Upon initial recognition, it is designated by the entity as at fair value through profit or loss.
Note: Investments in equity instruments that do not have a quoted market price in an active market, and whose fair value cannot be reliably measured, should not be designated as at fair value through profit or loss.
Available-for-sale
Available-for-sale financial assets are those non-derivative financial assets that are designated as available for sale or are not classified as one of the other types of assets mentioned already, namely:
- Loans and receivables.
- Held-to-maturity investments.
- Financial assets at fair value through profit or loss.
FAIR VALUE MEASUREMENT CONCEPTS
The fair value of a financial asset or liability is the amount for which the financial asset could be exchanged, or the financial liability settled, between knowledgeable, willing parties in an arm’s length transaction. The presumption is that an entity is a going conc...
